Dumping your bond funds? Read this first

Commentary: How to make sense of the mad dash for the exits

That’s not just the choice that most investors face every morning, it’s what they had to decide recently after Federal Reserve Chairman Ben Bernanke hinted that the central bank will soon end its program of buying bonds to support the market and keep interest rates low.

While many observers felt that Bernanke was simply floating a trial balloon — trying to gauge the market sentiment while also sparking some movement in a bond market that had grown increasingly complacent — others took his words as a call to action, jumping out of their long slumber in bonds to move their money elsewhere.

As a result, through Monday, June 24, more than $61.7 billion had flowed out of bond funds and exchange-traded funds, according to TrimTabs Investment Research, a record rush for the exits that is nearly 50% larger than the prior record, set in October of 2008 as the market was reaching the peak of the financial crisis.

The move bucks a long and determined trend. Until June and Bernanke’s statements, investors had been plowing money into bonds consistently, despite paltry yields, because they believed that the Fed would provide sufficient liquidity to prop up the market forever.

A month ago, junk bond yields were falling below 5% for the first time, a sign that investors who were still skittish about stocks (despite an equity run to record-high levels) were feeling that there wasn’t much danger in bonds, even in paper that was classified as risky.

That changed with a few statements from Bernanke.

It’s no secret how bond funds and the bond market works. When rates rise, bond prices go down; a bond fund’s share value is determined by what it could sell those bonds for if it needed to liquidate, so if rates go up and prices go down, bond funds suffer.

Experts have been warning of a building bond bubble for years; even if the market can avoid a catastrophic event, investors clearly expect a lot of pain when rates move up, despite the relative safety of the asset class. Even if that pain is temporary — and bond funds typically recover from the declines suffered during a rate hike by bringing in more yield as they buy new paper at the better rates — investors don’t want to feel it.

Investors flee from bonds

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Fear of Federal Reserve tapering has hammered government bonds; here's where to invest instead.

Thus, Bernanke’s talk created a rush for the exits; June’s record exodus marked the first month in nearly two years where bond funds saw net outflows.

The question, of course, is “What did investors do with that money?”

The answer, from TrimTabs’ research and numbers released by the Investment Company Institute, is clear; it did not go into stocks. Through June 24, according to TrimTabs, only $400 million — less than 1% of the bond outflow — had been shoved into equity funds in June.

“That money is not going to stocks, it’s going into bank products and money-market funds, even if investors don’t think they will get any real return there,” said David Santschi, chief executive officer at Trim Tabs Investment Research. “Bond money for most investors is considered their safe money; even if they don’t understand the risks they believe that what they can’t afford to lose they put into bonds, and while they might not be happy with a loss in a stock fund, they won’t even tolerate the thought of a loss in their bond funds.”

The question is whether such a loss in bond funds is imminent, and whether investors can afford to snooze right now and wake up later.

Michael Gayed, chief investment strategist at Pension Partners, said the current market movement has been an over-reaction, noting that “While there is a concern that bonds are over-valued — that there is a bond bubble — it’s not really a bond bubble unless you have an end to deflationary forces.”

With no such end in sight, at least for the rest of 2013 if not much longer, there is nothing to justify an immediate change to Fed policy or the higher yields that would drop bond prices and hurt bond funds.

Despite Bernanke’s words and warnings, nothing seems to have changed; the market simply had a tantrum over his words.

For investors who are between snoozing and jumping out of bed, what’s needed is a quick evaluation.

With Bernanke hinting at an inflection point where policy changes, investors should look at all of their income-oriented investments — including dividend-producing stocks — and consider rebalancing back to their planned allocations, rather than allowing market forces to push them forward, particularly in bond funds with longer maturities.

Said Santschi: “Is it scary how much the Fed is driving this market? Absolutely. But does that mean the average investor should be rushing to sell all of their bond funds? I don’t think so. If you’re careful, there is never a reason to panic, but there is really no reason to panic right now, and you’re not going to help yourself if you see all this money leaving bond funds and you just think ‘They’re all going so I have to get out too.’”

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